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Inflation risk is significant when exchanging reals for nominal dollars. Rather than ending your fear of saving your 401(k), QLACs can actually strengthen it.
The Wall Street Journal of July 23, 2023 included an article on QLACs – Qualified Duration Annuity Contracts – with this, to me, eye-opening headline, “A Retirement Tax Break That Takes the Fear Out of Surviving Your 401(k).” Ashley Ebling’s article begins with this paragraph:
Millions of Americans have good reason to believe their retirement savings will survive. A little-known tax-advantaged annuity can help you avoid this, providing a guaranteed income in the later years of life.
An annuity, in its simplest form, involves transferring money to receive a fixed income stream that will continue until death. A QLAC is a special type of annuity. Delayed. You’re handing over money now for a life-saving contingent income stream that kicks in at some point in the future.
Ebling offers the example of a 65-year-old buying a QLAC for $200,000 today that would pay out $134,100 a year starting the year the person turns 85. That certainly sounds like a fabulous deal.
Even better, there’s a potential tax break. The $200,000 a person spends on a QLAC is exempt from required minimum distributions (RMDs). Depending on people’s ages, RMDs start at age 73. (Last year’s Secure 2.0 Act raised the starting RMD age for the current 65 to 73 from 72. For those born in 1960 or later, the starting RMD age is 75.) Yes, a person will have to pay taxes after age 28. reach 73 years. And if they die before age 85, they avoid paying taxes on the $200K payout entirely!
If this all sounds too good to be true, it is.
For starters, a person, if male, has only a 55 percent chance of reaching 85. Then there is the crucial word – inflation, which appears more than once in a magazine article. Let’s assume that inflation for the next 20 years accumulates as it has for the past 20 years. Then paying $134,100 would lose 38.6 percent of purchasing power over the next 20 years. This is all before the QLAC annuitant receives any income on the policy. In other words, the first year’s payment, starting at age 85, would be just $82,337 in today’s dollars. Multiply that by 0.55, assuming the man lives to age 85, and we’re talking about an expected real payment of just $45,286 in the first payment year.
But the real yield on a 20-year inflation-indexed bond is currently 1.58 percent. And the discount factor to the real dollar after 20 years is currently 0.73. Multiply $45,286 by .73 and we’re talking $33,058 as the QLAC’s expected present value in the first year.
That’s only 16 percent, not 67 percent ($134,100 divided by $200,000) of the original $200,000 investment. Moreover, today’s 85-year-old man has only 6 years left to live on average. With that in mind, factoring in the likelihood of inflation, potentially super-high inflation, after age 85, and real discounting, the QLAC’s total expected value of nominal payout from age 85 to death isn’t that great anymore. Indeed, it can be well south of $200k.
The difference between the expected value on the QLAC and the $200K immediate expense is the QLAC’s load value—its load. To be fair, this load may be no more than, say, immediate annuities or term life insurance policies. But determining this fact requires a detailed actuarial analysis that includes not only the probability of survival, but also the probability of future inflation rates.
Of course, no insurance policy is a slam dunk. They all have loads. And our concern about risk drives us to buy insurance even when the burden is high. But, at some point when the load is too high, buying a policy doesn’t make sense compared to taking the risk and self-insuring as much as possible. Self-insuring options here include saving more, downsizing and moving to a lower-tax state, working longer, optimizing lifetime Social Security benefits, and tax-efficient Roth conversions.
Even today’s 65-year-old can do it real Unlike nominal insurance arrangements with one’s children, siblings or close friends. This paper is entitled, The family as an incomplete annuity market, which I co-wrote with Israeli economist Avi Spivak, is now almost half a century old. But most economists who study annuities, whether immediate or deferred—especially the question of why so few people buy them—know the paper and its message. Family insurance can avoid the burden of Adverse selection (Insurance consumers know things, including their odds of making it to 85 and over, compared to insurance companies), and, more importantly, inflation is implicit in real, not nominal, home insurance contracts.
But let’s assume that the 65-year-old man in question is single or not on speaking terms with his 4 siblings and 5 children, let alone forming an implied, let alone overt, real annuity arrangement with them. So longevity is a big risk for this 65-year-old. Thus, this potentially very expensive QLAC could be worth it if inflation were to develop as expected. Unfortunately, like human life expectancy, future inflation is anyone’s guess. Of course, the markets had no idea it would return in 2020.
Thus, buying a QLAC reduces a person’s exposure to one major risk—life expectancy risk—but increases another—inflation risk. However, the title of the journal article (note: editors, not writers, almost always choose titles for journal articles). QLAC, the title says, ending Fear of saving your own 401(k). This is certainly not the case if we are talking about real spending as opposed to nominal spending power. And the actual spending is the only thing that matters.
Regarding the claim that QLAC is a “tax benefit”. Again, not so fast. Yes, a prospective QLAC buyer will pay no tax on the $200,000 between ages 73 and 85. On the other hand, if a person lives to take advantage of QLAC payments, whatever their actual values are, their tax bracket may be much higher than it would have been had they not purchased a QLAC. The reason is that the person will collect more tax dollars in fewer years, potentially pushing them into higher tax brackets.
Moreover, our federal income tax and 42 (including Washington, DC) state income taxes on income from nominal, not real, assets. Much of the future taxes imposed on the $134,100 represent taxation of the inflation component of the $134,100—the fact that its value is much higher given the inflationary expectations embedded in today’s long-term nominal interest rates.
But put inflation aside to focus on the tax bracket. Of course, tax deferrals provide more content. But putting yourself in a higher tax bracket can more than offset that advantage. Indeed, as illustrated here, retirees may do better in reducing lifetime taxes by starting tax-deferred withdrawals as soon as they retire, which, for most early retirees, is in their early 60s. Unfortunately, there is no one-size-fits-all rule. Much depends on when a person begins receiving Social Security benefits, which can be taxed prematurely by early withdrawals.
The Medicare Part B progressive IRMAA premium is also included in the QLAC decision. The upper premium bracket is not indexed for inflation. Therefore, big nominal QLAC payments starting at 85 could place our hypothetical deferred annuitant in the highest IRMAA bracket.
Overall, there are a number of critical considerations when evaluating QLACs. Our country is broke for the long term and is using inflation to reduce debt. This is more likely than not to last. Therefore, the risk of high and volatile future inflation is very real and very important to those who consider the real dollars they have today in nominal dollars—literally pieces of paper called dollar bills—that will be paid off decades from now, if at all, and have little to no purchasing power. So, rather than “ending” your fear of surviving your 401(k), QLACs can greatly enhance it.
